Modes of Financing

Loans

Modes of Financing: Islamic Banking

Modes of Financing - Introduction

The concept of musharakah and mudarabah envisaged in the books of Islamic Fiqh generally presumes that these contracts are meant for initiating a joint venture whereby all the partners participate in the business right from its inception and continue to be partners upto the end of the business when all the assets are liquidated. One can hardly find in the traditional books of Islamic Fiqh the concept of a running business where partners join and leave the enterprise without affecting in any way the continuity of the business. Obviously, the classical books of Islamic Fiqh were written in an environment where the large scale commercial enterprises were not in vogue and the commercial activities were not so complex as they are today. Therefore, they did not generally dwell upon the question of such a running business.

Project Financing

In the case of project financing, the traditional method of musharakah or mudarabah can be easily adopted. If the financier wants to finance the whole project, the form of mudarabah can come into operation. If investment comes from both sides, the form of musharakah can be adopted. In this case, if the management is the sole responsibility of one party, while the investment comes from both, a combination of musharakah and mudarabah can be brought into play according to the rules already discussed.

House Financing

House financing arrangement is composed of the following transactions: 1. To create joint ownership in the property (Shirkat-al-Milk). 2. Giving the share of the financier to the client on rent.

Carrying Business of Service

The second example given above for diminishing musharakah is the joint purchase of a taxi run for earning income by using it as a hired vehicle. This arrangement consists of the following ingredients: i) Creating joint ownership in a taxi in the form of Shirkah al-Milk. As already stated this is allowed in Shariah. ii) Musharakah in the income generated through the services of taxi. It is also allowed as mentioned earlier in this chapter.

Sharing in the Gross Profit

Financing on the basis of musharakah according to the above procedure may be difficult in a business having a large number of fixed assets, particularly in a running industry, because the valuation of all its assets and their depreciation or appreciation may create accounting problems giving rise to disputes. In such cases, musharakah may be applied in another way.

Diminishing Musharakah in Trade

The third example of diminishing musharakah as given above is that the financier contributes 60% of the capital for launching a business of ready-made garments, for example. This arrangement is composed of two ingredients only: 1) In the first place, the arrangement is simply a musharakah whereby two partners invest different amounts of capital in a joint enterprise. This is obviously permissible subject to the conditions of musharakah already spelled out earlier in this chapter.

Musharakah – Dishonesty

Another apprehension against musharakah financing is that the dishonest clients may exploit the instrument of musharakah by not paying any return to the financiers. They can always show that the business did not earn any profit. Indeed, they can claim that it has suffered a loss in which case not only the profit, but also the principal amount will be jeopardized.

Financing of the Working Capital

Where finances are required for the working capital of a running business, the instrument of musharakah may be used in the following manner: (1) The capital of the running business may be evaluated with mutual consent. It is already mentioned while discussing the traditional concept of musharakah that it is not necessary, according to Imam Malik, that the capital of musharakah is contributed in cash form. Non-liquid assets can also form part of the capital on the basis of evaluation. This view can be adopted here. In this way, the value of the business can be treated as the investment of the person who seeks finance, while the amount given by the financier can be treated as his share of investment. The musharakah may be effected for a particular period, like one year or six months or less. Both the parties agree on a certain percentage of the profit to be given to the financier, which should not exceed the percentage of his investment, because he shall not work for the business. On the expiry of the term, all liquid and non-liquid assets of the business are again evaluated, and the profit may be distributed on the basis of this evaluation.

Musharakah - Business Secrecy

Another criticism against musharakah is that, by making the financier a partner in the business of the client, it may disclose the secrets of the business to the financier, and through him to other traders. However, the solution to this problem is very easy. The client, while entering into the musharakah, may put a condition that the financier will not interfere with the management affairs, and he will not disclose any information about the business to any person without prior permission of the client.

Risk of Loss in Musharakah

It is argued that the arrangement of musharakah is more likely to pass on losses of the business to the financier bank or institution. This loss will be passed on to depositors also. The depositors, being constantly exposed to the risk of loss, will not want to deposit their money in the banks and financial institutions and thus their savings will either remain idle or will be used in transactions outside of the banking channels, which will not contribute to the economic development at national level.

Running Musharakah Account

Many financial institutions finance the working capital of an enterprise by opening a running account for them from where the clients draw different amounts at different intervals, but at the same time, they keep returning their surplus amounts. Thus the process of debit and credit goes on up to the date of maturity, and the interest is calculated on the basis of daily products.

Securitisation of Musharakah

Musharakah is a mode of financing which can be securitized easily, especially, in the case of big projects where huge amounts are required which a limited number of people cannot afford to subscribe. Every subscriber can be given a musharakah certificate which represents his proportionate ownership in the assets of the musharakah, and after the project is started by acquiring substantial non-liquid assets, these musharakah certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. However, trading in these certificates is not allowed when all the assets of the musharakah are still in liquid form (i.e., in the shape of cash or receivables or advances due from others).

Unwillingness to Share Profits

Many a time, it is mentioned that the clients are not willing to share with the Banks the actual profits of their business. The reluctance is based on two reasons: 1. They think that the bank has no right to share in the actual profit, which may be substantial, because the bank has nothing to do with the management or running of the business and why should they (the clients) share the fruit of their labour with the Bank who merely provides funds. The Clients also argue that conventional banks are content with a meagre rate of interest and so should be the Islamic Banks.

Equity Screening in Islamic Finance

The most important aspect of Islamic Equity Funds is Shari’ah screening. We can classify the Shari’ah restrictions on the types of equities m the fund in two categories:

Hawalah vs. Wakalah vs. Kafalah

There are various legally recognised forms of financing contracts in Islam, and Hawalah, wakalah, and kafalah are three most commonly used concepts in modern Islamic banking. To a great extent, hawalah resembles kafalah and wakalah since these contracts involve transfer of risk and control. The main difference between hawalah and kafalah is that the principal debtor is released from the debt under hawalah contract whereas kafalah is not.

Wakala Deposit

Wakalah is an agency contract, where the account holder (principal) appoints an Islamic finance institution (agent) to carry out investment activities claims that wakalah “allows a much more efficient recycling of short-term liquidity in the Islamic banking system”. Islamic banks and financial institutions offer wakalah contracts in many different forms, including letter of credit, Islamic monetary certificate, Islamic bonds, term deposit, and Islamic insurance.

Kafalah

Kafalah is the guarantee for a loan and all loans must be repaid in due course according to Islamic law. The law allows the lenders to demand some sort of security for the loan in the cases where the borrower fail to repay the loan. As for the Shariah Advisory Council of Bank Negara Malaysia, kalafah is defined as a guaranteed contract on certain asset, usufruct and/or services provided by a guarantor to the parties involved.

Hawalah-based financing

The contract of Hawalah is commonly used in contemporary banking, namely bill of exchange, promissory note, cheque or overdraft. It refers to transfer of debts from the transferor or the original debtor to the payer.